Total Return vs. Income Investing

What's the Difference and Why is it Important to Understand?

Oftentimes, when discussing investment strategies, especially as they relate to stocks, it is often about whether to take a growth or value-oriented investment approach. In the former you're interested in companies that you believe are growing and will appreciate in price, and in the latter you are interested in companies that may be considered undervalued and can be purchased at price below their true worth. In either scenario, the end game is total return; which is a combination of the investment's gain/loss in price + whatever dividends you receive. Thus, a stock purchased for $10/share that appreciates to $10.75 and pays a $0.25 dividend would provide you with a total return of 10% ($10.75 - 10.00 + 0.25) / $10 or $1.00/$10.

In this low interest rate environment, many investors are drawn to trying to find investments that generate income as their sole or primary investment objective.  As such, investing strictly for income is different than investing for a total return (i.e., appreciation in value + income). Additionally, even though high income producing investments have become all the rage, they can become expensive due to high demand and actually become more volatile and subject to greater price declines when interest rates go up. 

No one's saying income generation shouldn't be a goal for  investors. It is, after all, one of two key components of the total-return equation. The other, obviously, is price appreciation. 

Income producers--whether bonds, dividend-paying stocks, real estate investment trusts or master limited partnerships--can be an important component of investors' portfolios. Also, they grow in importance as a percentage of our portfolios as we age: Focusing on securities with the ability to pay income adds a valuable quality to a portfolio, as income production can be an important indicator of a company's financial wherewithal. From a practical standpoint, income can also provide a cushion on the downside when the market is falling. 

True, the goal for many income investors is to not touch principal but rather to fund expenses with the income that their portfolios generate. In contrast, total-return investors don't reflexively avoid tapping capital for living expenses; retired total-return investors might employ a bucket approach strategy where they have buckets of investments with different objectives (i.e., safety, income, growth, etc.). 

The goal of the total-return strategy is to grow the overall portfolio by maintaining a diversified basket of investments--some income-producing, some that will contribute to the bottom line by appreciating in price, and some that do both. 

The big-picture goals of growing and maintaining a portfolio are the same for both income and total-return investors. 

Combination of the Two

In the end, I think the best answer for most investors is to give due consideration to securities' income-generating potential, but within a total-return framework. 

Blending the two approaches allows investors to benefit from the stability that income-producing securities bring to the table without sacrificing diversification or chasing securities that, in hindsight, turn out to be yield traps. 

A yield trap can occur when an investment appears attractive due to its high yield (i.e., interest rate or dividends paid), but there are other issues not taken into account: 

  • The price of the investment has appreciated due to investor demand and now is overpriced compared to the market. 
  • The company's financial footing is such that it may not be able to continue paying the high yield and subsequently may actually reduce or cut its dividend. 
  • Interest rates tick up and the high yield investment has a much greater decline in value as compared to the overall market. This is due to the fact that these type of investments can be much more interest rate sensitive, which is good if interest rates are declining, but not so good when they are on the increase. 

 

Unfortunately, the trap occurs if the investor purchases an investment that is hit by one or several of the above items, which results in the investor feeling trapped. Often, a yield trap appears to be such a good deal that investors subsequently become confused when the investment fails to perform. 

Embedding income producers into a total-return strategy has a couple of other key side benefits. One is tax management: focusing on total return gives investors more control over when they harvest income from their portfolios and where it comes from--a particularly important consideration for investors with substantial assets in their taxable portfolios. A total-return-oriented investor might wisely decide to hold income-producing securities in his/her tax-sheltered accounts, while steering non-dividend payers and/or more growth-oriented investments to the taxable account. 

The bottom line? Resist the urge to classify yourself as either an income or total-return investor. When it comes to the health and stability of your portfolio, the best answer is "both." 


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